A Structurally Sick Economy

Not much happened in the financial markets overnight. Europe was in the red on renewed concerns over the health of the peripheral nations of Portugal, Spain and Greece. The US backed off a little as everyone awaits ‘the man’ tomorrow, the US dollar was weak and gold was up a little bit…but still below the important US$1,300 threshold.

In short, nothing to see here.

But two data points did catch our eye and go some way towards explaining just what is going on in the world at the moment. They represent an ideological battle of sorts…Keynes versus Hayek, hard money versus soft.

The first data point was a 5.6% year-on-year fall in new car sales in the European Union. They are at their lowest level since 1996. That’s a slight improvement from May, when sales scraped along at a 20 year low.

The next release, or rather releases, that caught our eye were the supercharged profit performances of the big US investment banks. Goldman Sachs reported a near doubling of second quarter profits (compared to last year) and JP Morgan and Citigroup also reported strong earnings this week.

So what’s the connection between the two? We’ll get to that in a moment.

In Europe, such poor economic data gets a lot of condescending media commentary from the Anglo West. ‘Europe is a basket case, the monetary union is a joke, a break-up is the only way out of the current economic malaise.’

These comments all have an element of truth to them. But they are also missing a much larger point. That is, Europe is undergoing a major economic restructuring. Stated more accurately, Southern Europe is undergoing a major economic restructuring. But because Northern Europe is the largest supplier to the south, the whole economy is undergoing change. Structural change. Keep that phrase in mind.

The driving force of this change is restrictive credit. The peripheral nations enjoyed a credit bonanza when they joined the euro in 1999. Interest rates under the euro were lower than they ever were under the individual currencies.

But the credit boom ended in 2008. The flow of easy credit dried up and now interest rates in these nations are much higher. If easy credit and debt growth brings forward demand, the lack of easy credit quashes it. If the south isn’t buying, it reduces northern Europe’s income, which stops the north from buying too. Which is why Europe is suffering from the lowest total car sales in nearly 20 years.

Meanwhile, in the US the big investment banks are making money hand over fist. Goldman Sachs enjoyed a 30% year-on-year jump in revenue for the second quarter as the value of its investments rose and fees from debt underwriting jumped.

Marking your assets to market (in a rising market), booking the change as revenue and profits, and making money from enabling others to borrow, is a direct benefit of easy money. Goldman’s share price is up over 60% over the last 12 months. JP Morgan has seen its share price rise 56% and Citigroup, on the verge of bankruptcy in 2008, saw its shares jump nearly 100% over the past year.

A liquidity flow of $85 billion per month from the Fed and a commitment to easy money for years to come certainly helped the banks to achieve such strong profit and share price growth.

But we ask, what is all this doing to the structure of the economy?

Structural change is a widely used term, but one that not enough people really think about. What does economic structure, and a change in economic structure, really mean?

The structure of an economy is determined by many things…natural resources, geography, historical development and government policy. But probably the most important determinant of an economies structure is interest rates.

Years of low interest rates and easy credit can markedly change (distort) the structure of an economy. For example, in Australia, loans for business (productive enterprise) versus housing used to be about 50/50. That was around 20 years ago. Now, it’s closer to 30/70.

That is, much more debt has gone into property than enterprise. This flow of debt capital has pushed house prices up, created ‘wealth’ for property owners, which in turn has led to big increases in consumption. It has also facilitated a drop in Australia’s productivity. And improving productivity is all about ‘structural reform’ a task no government will seriously tackle in an era of easy money.

So the ‘structure’ of Australia’s economy grew around this. Shopping malls sprang up everywhere (the rise of Westfield) and the services sector experienced massive growth. Governments became reliant on this structure too. For example, the State governments main source of revenue is from stamp duty on property transactions.

If we look at China’s credit boom, it is well known that the benefits flowed through to Australia via higher iron ore and coal prices. It led to huge investments and demand for labour, the rise of unions, soaring wage rates and a tattoo parlour boom. It changed the economic structure.

And in the US, a large part of the economic structure is dependent on easy money. It’s not just the investment banks. They’re just first in line to clip the ticket when the money flows from the source, the Federal Reserve. Housing and household ‘wealth’ relies on easy money, which supports a whole economic sub-structure.

Getting back to Europe’s car sales, it’s interesting to note that in the UK, new car registrations jumped 13.4% in the year to June. The UK is firmly following an easy money path, pushing house prices back up to record highs, enabling households to use the ‘equity’ to buy a new car.

And you shouldn’t be surprised to hear that with Australia’s indestructible house prices, new cars sales here continue to grow at a solid rate. One of the quickest and least painful ways to get a new car is to put it on the housing loan.

What’s the point in telling you all this?

Europe is undergoing an economic restructuring, the rest of the developed world is not. Maybe that’s because they haven’t had a ‘Greece’ moment. Whatever, the Europeans are shying away from reverting to easy money every time the economy wobbles.

Western Keynesians snigger at them for doing so, but Europe has a long history of bungling monetary management. Both France and Germany have suffered hyperinflation. The peripheral economies have all suffered chronic inflation before joining the euro.

Europe is taking its medicine now while it still can. The Anglo West doesn’t even know it is sick.

Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Sound Money. Sound Investments, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market.
To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.

I think it is more like 95% of Australian loans are for or “backed” by real-estate. Genuine business loans are so tiny as to be negligible. Pretty much explains the gutting of Australian manufacturing.

Why not 99% of the problem, Ram? Nothing to do with our high wages (and higher standard of living) or our relative isolation from markets (transport), or our relatively tiny domestic market, either. Housing is to blame.
Almost seven years have passed now, with the prophets forecasting imminent doom’n’gloom for the property market, that most evil nemesis of Australian manufacturing. ;)

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